Monthly Archives: September 2010

What are the combinations of personal and theoretical knowledge that one finds among market participants?

1. Poor personal knowledge: This describes both the cynic and many unsuccessful traders. They have tried to get to know the market and have either proved incapable of achieving a sufficiently different personal understanding from the one they use to understand other people, or have not yet reached personal understanding.

2. Good personal knowledge: Successful day-traders may fit into this category. After years living with price, volume and newsflow, they have come to understand the market well enough to make money on average. A systematic trader who has found a method that works, but does not know why it works, also fits in here. They are likely to struggle if market conditions change significantly (for example, those raised in bull markets may struggle in bear markets).

3. Personal familiarity and a theoretical toolkit: Some (not all!) asset allocators and brokers are my model for this category. A person can thrive in either job without making money from tactical trades or stock picks on average. They will be comfortable with the behaviour of the markets, having been around them for many years, and will have a toolkit of theoretical concepts that have been used to understand the markets. They will pick concepts from the toolkit to support their latest market views. Essentially, people with type 3 understanding do well by aping the behaviour of people with real personal and theoretical understanding.

4. Personal knowledge and implicit theory: I have met fund managers that fall into this category. A person can be a good fund manager because he has a good feel for the behaviour of stocks, say, or the behaviour of markets after data releases, and a consistent methodology that makes money on average. He will not necessarily have, and indeed does not need to have, an explicit understanding of the theory embodied in his methodology. The training of equity analysts in established valuation methods may lead them to be type 4 (for this reason I used to ask fund managers to describe the intellectual journey that had brought them to their way of doing things, rather than asking them to lay out the theoretical underpinning of their methods). Poor fund managers may be type 3.

5. Pure theory: This is the realm of the systematic trader who thinks he understands why his trading method works.

6. Personal knowledge and explicit theory: It is tempting to assume that this is nirvana for the discretionary trader. I have often read that the best traders are the ones who have developed their own theory of the markets. One objection to this idea is that it is important that the theory is at least partially true; another is that the theory does not have to be one’s own, as long as it is deeply understood. Further, it may be that the requisite personal knowledge for a trader on my time scale — with a holding period of weeks to months — is entirely negative (i.e. it is about learning what not to believe — “this market has gone far enough,” “buy the dips,” “you can’t go broke taking profits,” etc.), or there may be a lot more to it. In other words, knowing how to achieve nirvana is not as easy as it sounds. I hope to develop this in some further posts.

Going out on my own as a trader was really about trying to make the transition from type 3 to type 6.

How is it possible to understand the market? I have been thinking about this question this week.

What are human beings able to understand? The most obvious and natural thing is other people. We have evolved in social groups and one of our most developed mental skills is the ability to navigate within them. We are able to use subtle cues to infer the thoughts and emotions of members of a group and to create a map of how they fit together.

We are also able to understand theory. We can take a set of principles and apply them to a particular case. If it is combined with a good method of building a theory — science — we can gain a robust understanding of natural phenomena by this method.

Understanding through theory is much harder than understanding people in our social groups. One needs to spend many years training to be a scientist, or priest, or astrologer, for example. One must spend many years immersed in a theoretical framework to apply it accurately and consistently. Consequently, people who have not spent this time and effort often attempt to understand in a personal way things that are best understood in a theoretical way. Here are some examples:

Dogs. Expert dog handlers have learnt to act in ways that will, generally, get dogs to do what they want. The fundamental elements of this knowledge can be transmitted theoretically relatively easily to intelligent participants in dog training classes or in books. But many new pet owners fail to seek out the theory, treat their dogs as people and reap a harvest of bad behaviour.

Nature. Primitive cultures tend to personalise natural events and objects — volcanic eruptions, winds, trees, even rocks. Children fear not the dark, but malicious creatures that they imagine to be hidden by it. Christians cannot help believing in a personal explanation for the origin of the universe.

Economics. The recent trend towards fiscal austerity has a moral element. Bankrupts recover from economic and social ruin by wearing a hair shirt and living within their means. People think, wrongly, that this must also be true of firms and of countries (more from Paul Krugman).

There are many more examples.

We understand members of our own culture much better than members of other cultures, so there must be an element of learning involved in personal understanding. This learning is best undertaken in childhood, but clearly it is possible to gain a personal understanding of certain subjects. One may come, after long exposure, to understand dogs or foreign cultures almost as well as one understands one’s own family. But that does not necessarily happen: dog owners can spend a lifetime treating their pets like people, and expats can become cynical about their foreign hosts.

I have seen the tendency towards cynicism in people who try to understand the markets. “This is bad news so obviously the freakin’ [sic] market will go up” is not an unusual comment on blog posts. These people are like the expat who spends all his time drinking in the Colonial Club — they have tried to understand the market using their preconceptions about how a person should behave, found that it sometimes does, and sometimes does not, and concluded that it is at best capricious and at worst out to get them. A small number of people, however, manage to develop a sufficiently good personal understanding of the market to trade it successfully — pit traders being the classic example. These people are like the expat who builds a circle of local friends by getting to know their mores. He may always be a foreigner, but he will be good enough at predicting his hosts’ behaviour to live among them successfully.

As with gold, treasuries are rising in anticipation of further QE. I am less sure about this trade — breakouts have not been a wildly successful way of trading this market historically. However, with the yield slipping below 2.5%, this is a major breakout to yield levels not seen since (I think) the 1950’s, and the market has just had a good pullback which means this bull run is relatively young.

Analysis

When the Fed minutes were announced yesterday, risk assets took them as doveish on inflation and suggestive of QE. My QE trade rallied, except for treasuries, which dropped because of a suggestion in the minutes that the Fed might focus on GDP growth rather than inflation in deciding whether to go on with QE — which is mildly positive for future inflation.

I am torn about whether to close the trade or not. With the trend in place and less than 1ATR of profit, the bias must be towards keeping it, and the hope that further QE will create the conditions for higher inflation has been part of the story from the start and has not stopped Treasuries from rallying. I do feel cautious, however — the market could now focus on this aspect of the story.

Here is a chart:

Update: This story says that the Fed is considering targeting higher inflation. With this trade at around half a risk unit of profit the market is too close to my stop for me to be sanguine. Expectations of extraordinary Fed action can no longer be expected to raise Treasury prices — they may raise or lower them, depending on how this story plays. I have therefore taken profit on this trade.

Gold has broken 1300, on an uptrend, on the back of expectations of further QE (and, relatedly, a falling USD).

The only reason not to trade would be that the trend is getting a little old, in the short term (extension from the trend line) and medium term (as shown by the trend age page below). The QE story may be strong enough to keep the market moving, however, and the break of 1300 will bring in people who have been waiting to buy on a pullback. Trading the breakout right away is more effective than trading a retest in this market.

The piece suggests that closeness to “very serious people” is stifling for the individual mind. I think it is worse than that: being a very serious person is also stifling. There is a particular kind of stupidity exhibited by intelligent and powerful people that comes from a lack of challenge. We cannot constantly re-examine all of our assumptions without outside help. If you are intelligent and powerful then you are unlikely to spend enough time with people who are sufficiently focussed on your area of expertise to have a good understanding and sufficiently unawed by your standing to have your dafter beliefs seriously challenged. And this is especially true of beliefs that are peripheral to your reasons for being a very serious person (hence the spectacle of Nobel laureates talking nonsense outside their own fields).

It was hot this morning, hot and humid, but a lot of people on the streets of London were wearing coats. Why? I have thought of a few possible reasons.

It was cold when they left home. This is unlikely — I was out having a run at 0615 and it was not cold.

They fear that it might be cold later.

They automatically put a coat on from mid-September onwards.

They automatically put a coat on when the weather is overcast.

They do not yet have the heating on in the morning and were cold in the bedroom or bathroom.

They do not carry umbrellas and want to protect their clothes if it rains.

Probably the explanation is a combination of 2-6.

Is this an instance of satisficing behaviour? People dislike cold and rain and adopt a rule that is good enough at making them less unpleasant — always put a coat on if… — even though on many days they will be hot and sweaty in their coats, and when it rains they will get wet hair.

Sometimes people whom I know well enough that I give voice to an inner monologue accuse me of moaning all the time. In fact I am generally not moaning, but re-examining my approach to some problem (how to put butter onto bread, how to get the best view of the beagles, how to minimise my journey time to work, to give three recent examples). I do not satisfice as much as my peer group. How far is this a useful tendency, and how far is it harmful by keeping too much in flux? As I have said before, one problem with my trading is that I am excessively open to changing my trading method.

I have done a 180-degree spin in my view on future Fed action. I am long equities and the AUD and short the USD.

I am having a hard time thinking of reasons that the market could go down. If the economic news is bad, markets will anticipate further QE. The market may even prefer bad news on the economy because it will mean the Fed provides a lot of liquidity that will not be invested in productive activity and will therefore find its way into financial assets. If, on the other hand, there is surprisingly good news on the economy, equities should still rally. Even if the newsflow is neutral for the next month, the drumbeat of news pieces on QE and regional Fed people giving interviews about it should support risk assets.

So I can’t see risk assets falling until after the next Fed meeting — and then only if the Fed thinks the economic news is strong and does not embark on more QE, while at the same time the market thinks the news is weak (which would be a pretty surprising failure of communication on the part of the Fed).

Carrying on from my post last week about combining fundamental and technical views, I have been thinking about what should count as an argument for trading or not trading. I am still considering adopting the method I suggested in the earlier post of trading every breakout in a trending market until I get into it.

Arguments for trading

There is a trend OR a trend is beginning (fundamental or technical argument, or both).

AND there is a short-term technical signal.

Arguments for not trading when there is a short-term signal

There is no trend.

Trend is old OR trend may be turning.

Signals do not work in the market concerned.

Major resistance (e.g. top of a range) in the way of the profit target.

Trade would give too much exposure to a risk factor.

Upcoming data risk.

I am planning to make more use of the scanner function in Tradestation. I can now scan for both breakouts and retests of a breakout. When a market comes up on the scanner, there is a presumption in favour of trading it — and only the arguments for not trading listed above count as reasons for not doing so. I will try to state formally, before I enter a trade, the reasons why I think a trend is in place.

The USD is trending downwards following the announcement that more QE may be on the cards. I had breakouts on Friday against the EUR, GBP and SGD. I am reluctant to trade against the EUR because I am already long EUR/GBP, and I am cautious of USD/SGD because the Singaporean central bank regularly intervenes in the currency (it seems to be letting the currency band go at the moment, but I have no idea whether this will last — should have traded early when the band was broken). That leaves GBP/USD, and the trade has the advantage of hedging my EUR/GBP position against a spurt in the GBP. If EUR keeps strengthening and USD keeps weakening I should make money on both trades, GBP having been basically flat for a while.

Technically there is a major resistance level in the way of this trend at 1.60 (just beyond one risk unit of profit), but given the weakness of the USD it is not an unreasonable bet that this will get breached. The breakout was on high volume and with good thrust through to 5pm. Trading 10-day breakouts was the best strategy last time this market had a prolonged trend (shown in the charts; recently the lack of trend has made all long strategies very poor performers but breakouts have made money since the market turned around in May). Correlation with my other open trades is low, including with EUR/GBP, as developments in EUR and USD have driven the GBP in recent months. Stop is at 1 ATR.

Analysis

With hindsight this was not a great trade — I went long GBP/USD after the USD broke out against a range of currencies. It would have been better to pick a currency that was in a tightening cycle rather than the GBP, where more QE is a possibility despite the high inflation numbers. In fairness, I did short USD against AUD as well.

I did make a little money on it, however, and it combined well with long EUR/GBP to make long EUR/USD, which was a good trade to be in. Also, when I went into the trade, everybody was talking about renewed EUR sovereign risk. I thought this was probably nonsense but was also cautious on having another long EUR trade in case I was wrong, but wanted to be short USD against another major currency and was already long the EUR — so GBP was the default. In that light, the trade was not so bad.

Today I closed out the trade after GBP broke out to the downside against a range of currencies. I have shorted GBP/NZD, which broke a major support level.